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Poker Lessons for Investors

October 22, 2009

Today’s somewhat whimsical article comes courtesy of frequent contributor Dave Van Knapp. His site, SensibleStocks.com, is chock full of clear-headed ways to pick stocks and explains the oft-unappreciated role of dividends.

I enjoy playing poker, and there are many parallels between poker and investing. I play online on PokerStars.com. They have a tab called “Poker Strategy” for new players. I clicked on it, and I was struck by how much of their simple strategies and tactics apply equally to stock investing.

So I decided to translate their “Poker Strategy” into investment insights. While I have freely substituted investment terminology and added a few thoughts of my own, the basic structure of the following and most of its main points come directly from the PokerStars discussion.

Decisions for the New Stock Investor

To invest at a consistently winning level requires both time and effort. In other words, it takes work. To the extent you can, deciding which type of stock investor you want to be before you start will make your decisions easier. By “type of investor,” I refer to such choices as investing for growth, investing for dividends, using fundamentals, using technical analysis, and the like. There is nothing wrong with combining disciplines into a hybrid approach, or using different portfolios to pursue different strategies. But getting your basic strategies down — I recommend writing them out — is important.

Make Good Decisions — the Results Will Follow

Even the best investors in the world have losing periods. Don’t make the mistake of expecting to win every time you invest. Your goal should be to make decisions to the best of of your ability at all times. If you do, the total return on your investing will take care of itself, and it will improve as you improve the quality of your decions. Many investors make the mistake of judging their ability based on the results of each decision. Your goal should be to make the best possible play every time. The closer you come to this, the better your results will be.

By “decisions,” I refer to decisions to buy, hold, sell, or stay away entirely. Selling or staying away are investing’s equivalents to folding a hand.

The Mathematics of Poker

Investing is a mathematical game, and it’s a game of incomplete information. That may sound complicated, but it really isn’t. On a very basic level, winning investing starts with the selection of which stocks or ETFs to buy or (more importantly) to avoid. This is called “stock selection.” If you embark with the best decisions as well as you can determine them, you will increase your odds of overall investing success. In this context, stock selection includes not only identifying excellent companies or ETFs, but also determining favorable prices at which to buy them (“valuation”).

Beyond Starting Hands

Stock selection is fundamentally important, but it’s only one piece of the puzzle. Once you have mastered solid guidelines for purchase decisions, the next area you should work on is your play for the rest of the time. I call this “portfolio management.” The area that separates better investors from the rest is that the better investors tend to play much better during the remainder of the process, after the starting stock or ETF selections are made. This is especially true concerning the decisions made about when to end the holding period for every stock or ETF purchased. These skills involve risk management, stop-loss techniques, deciding when a trend has played out, recognizing red flags, knowing what to do when a company cuts its dividend, and the like. Even small improvements in an investor’s portfolio management can have a tremendous effect on that investor’s lifetime success.

Avoiding Tilt

Another meta-skill that should be part of a winning investor’s strategy is avoiding tilt. (“Tilt” is a poker term for someone who has gotten emotional — perhaps because of a bad result — and starts making bad decisions, perhaps in an effort to make it all back at once.) Your emotions can work against you, but only if you let them. Emotional play results in poor decisions and lost money. Tilting and steaming can happen to anyone, and sometimes the only cure is a break from the game. That’s okay; the game will still be there tomorrow.

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